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Crowdfunding and the Federal Securities Laws University of Nebraska - Lincoln DigitalCommons@University of Nebraska - Lincoln College of Law, Faculty Publications Law, College of 2012 Crowdfunding and the Federal Securities Laws C. Steven Bradford University of Nebraska-Lincoln, [email protected] Follow this and additional works at: https://digitalcommons.unl.edu/lawfacpub Part of the Legal Studies Commons Bradford, C. Steven, "Crowdfunding and the Federal Securities Laws" (2012). College of Law, Faculty Publications. 119. https://digitalcommons.unl.edu/lawfacpub/119 This Article is brought to you for free and open access by the Law, College of at DigitalCommons@University of Nebraska - Lincoln. It has been accepted for inclusion in College of Law, Faculty Publications by an authorized administrator of DigitalCommons@University of Nebraska - Lincoln. Columbia Business Law Review (2012), pp. 1-150 CROWDFUNDING AND THE FEDERAL SECURITIES LAWS C. Steven Bradford* Crowdfunding-the use of the Internet to raise money through small contributions from a large number of investors-could cause a revolution in small-business financing. Through crowdfunding, smaller entrepreneurs, who traditionallyhave had great difficulty obtaining capital, have access to anyone in the world with a computer, Internet access, and spare cash to invest. Crowdfunding sites such as Kiva, Kickstarter, and IndieGoGo have proliferated, and the amount of money raised through crowdfunding has grown to billions of dollars in just a few years. Crowdfunding poses two issues under federal securities law. First, crowdfunding sometimes involves the sale of securities, triggering the registration requirements of the Securities Act of 1933. Registrationis prohibitively expensive for the small offerings that crowdfunding facilitates, and none of the current exemptions from registration fit the crowdfunding model. Second, the web sites that facilitate crowdfunding may be treated as brokers or investment advisers under the ambiguous standardsapplied by the SEC. This article considers the costs and benefits of crowdfunding and proposes an exemption that would free crowdfunding from the registrationrequirements, but not the * Earl Dunlap Distinguished Professor of Law, University of Nebraska-Lincoln College of Law. An earlier draft of this paper was presented in a colloquium at the University of Nebraska College of Law. The\author also discussed crowdfunding at the 2011 SEC Government- Business Forum on Small Business Capital Formation. The author writes to thank the participants in both presentations for their helpful comments and questions. The author also writes to thank Victor Peterson and Kevin Davis for comments on an earlier draft. Finally, the author writes to thank the research assistants who worked on this article: Daniel Hendrix and, especially, Katharine Collins. Their work improved the final article immeasurably and made the author's work much easier. 2 COLUMBIA BUSINESS LAW REVIEW [Vol. 2012 antifraud provisions, of federal securities law. Securities offerings for an amount less than $250,000-500,000 would be exempted if (1) each investor invests no more than the greater of $500 or 2% of the investor's annual income; and (2) the offering is made on an Internet crowdfunding site that meets the exemption's requirements. To qualify for the exemption, crowdfunding sites would have to: (1) be open to the general public; (2) provide public communication portals for investors and potential investors; (3) require investors to fulfill a simple education requirement before investing; (4) prohibit certain conflicts of interest; (5) offer no investment advice or recommendations;and (6) notify the SEC that they are hosting crowdfunding offerings. Sites that meet these requirements would not be treated as brokers or investment advisers. I. Introduction ...................... ......... 5 II. An Introduction to Crowdfunding ...... ........ 10 A. What Is Crowdfunding?. ....... ...... 10 B. Types of Crowdfunding.................... 14 1. Donation Sites ........... ............ 15 2. Reward and Pre-Purchase Sites ..... ..... 16 3. Lending Sites (Peer-to-Peer Lending)...... 20 a. Sites Not Offering Interest . ........... 20 b. Sites Offering Interest.... ................ 21 4. Equity Sites ......................... 24 C. The Antecedents of Crowdfunding.. ........... 27 III. Are Crowdfunding Investments Subject to the Registration Requirements of the Securities Act? ...... 29 A. Are Crowdfunding Investments Securities? ..... 30 1. The Donation Model.................... 31 2. The Reward and Pre-Purchase Models ........ 32 3. The Equity Model.......................... 33 4. The Lending Model.................... 34 B. Registration and Exemption of Crowdfunded Securities Offerings ................... 42 1. Registration .............................. 42 2. Possible Exemptions Under Current Law ...... 44 a. Section 4(2), Rule 506, and Section 4(5).... 45 No. 1:11 CROWDFUNDING AND SECURITIES LA WS 3 b. Rule 505 .................... ..... 47 c. Rule 504 ................... ...... 47 d. Regulation A ............... ....... 48 IV. The Status of Crowdfunding Sites Under Federal Securities Law ..................... ....... 49 A. Are Crowdfunding Sites Exchanges? . ........ 50 B. Are Crowdfunding Sites Brokers? . .. ... 51 1. Engaged in the Business ....... ......... 53 2. Effecting Transactions in Securities ............ 54 a. General Guidance ............. ..... 54 b. Transaction-Based Compensation.......... 56 c. Involvement in the Transactions............ 61 i. Providing Advice or Recommendations ............... 61 ii. Structuring the Transaction.............. 63 iii. Receipt or Transmission of Funds / Continued Involvement after the Financing ................ ...... 63 iv. Involvement in Negotiations ............. 64 d. Solicitation and Advertising .. ........ 64 e. For-Profit Status.. ................. 66 3. Conclusion: Would Crowdfunding Sites Be Brokers? ....... 66 C. Are Crowdfunding Sites Investment Advisers?... 67 1. The General Definition of Investment Adviser ....................... ..... 67 2. In the Business ................. 68 3. For Compensation ............... ..... 69 4. Advice, Analyses, or Reports Concerning Securities ..................... ...... 69 5. SEC No-Action Letters ....... .......... 73 6. The Publisher Exception ........... ..... 77 V. Proposals to Exempt Crowdfunding.... ............. 81 A. The Sustainable Economies Law Center Petition............................... 81 B. The Small Business & Entrepreneurship Council Proposal ......... ............... 83 C. The Startup Exemption Proposal . ............ 84 D. The White House Endorsement ..... ........ 84 4 COLUMBIA BUSINESS LAW REVIEW [Vol. 2012 E. SEC Activity............................ 85 F. The SEC's Authority to Exempt Crowdfunding... 87 G. The Congressional Response ............... 88 1. House Bill 2930 ................ ...... 89 2. Senate Bill 1791 ................. ..... 91 3. Senate Bill 1970 ................ ...... 94 VI. The Costs and Benefits of a Crowdfunding Exemption.......................... 98 A. Capital Formation: The Need for a Crowdfunding Exemption ................ 100 B. Investor Protection: The Effects of Crowdfunding on Investors ............... 104 1. The Risks of Small Business Investment...... 105 2. The Financial Sophistication of the Crowd... 109 3. Crowdfunding and Small Business Investment Risk ... .................. 112 VII. A Crowdfunding Exemption Proposal . .......... 117 A. Restrictions on the Offering ............... 118 1. Offering Amount.......... ............... 118 2. Aggregation/Integration .......... ..... 120 3. Individual Investment Cap ..... ........ 122 a. The Individual Cap Related to Existing Exemptions ................ ...... 123 b. How to Structure the Cap ........................ 126 4. Should There Be Company Size Limits? ....... 132 B. Restrictions on Crowdfunding Sites ................... 133 1. Open Sites, Open Communication................. 134 2. No Investment Advice or Recommendations 136 3. Prohibition on Conflicts of Interests ............. 136 4. Notification to the SEC .......... ..... 137 5. Investor Education ................... 138 6. Funding Goals and Withdrawal Rights ........ 139 C. Other Possible Requirements ........ ...... 141 1. Non-Profit Versus Profit Status ..... ..... 141 2. Mandatory Disclosure by Entrepreneurs...... 142 3. Restrictions on Resale.................. 144 D. Preemption of State Law............ ..... 145 VIII. Conclusion ......................... ..... 149 No. I: 1] CRO WDFUNDING AND SECURITIES LA WS 5 I. INTRODUCTION Small businesses, especially startups, have a difficult time raising money. The usual sources of business finance- bank lending, venture capital, retained earnings-are difficult to obtain for small and micro-businesses. Wealthy individuals known as "angel investors" fill part of the funding gap, but angel investing is limited, and even angel investors tend to focus on larger investments. Entrepreneurs who lack the personal resources needed to finance their businesses turn to friends, family members, and personal acquaintances, but those sources are often insufficient. As a result, many potentially successful small businesses do not get funded. Crowdfunding, sometimes called peer-to-peer lending when it involves debt financing, is a possible solution to the small business funding problem. Crowdfunding, is, as its name indicates, funding from the crowd-raising small amounts of money from a large number of investors. Unlike typical business financing,
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